Tuesday, April 27, 2010

Own the Fed — the Program, Part IX: Stop Monetizing Government Deficits

In 1898, in a book with the somewhat intimidating title, Public Debts: An Essay in the Science of Finance (New York: D. Appleton and Company), Henry C. Adams warned of the dangers of permitting politicians to circumvent the taxation and appropriations process by allowing them to finance public expenditures by resorting to borrowing rather than taxation. While we are continually reassured that the gargantuan federal debt is nothing to worry about, and that the colossal amount of debt paper in foreign hands is not a cause for concern, history and common sense suggest otherwise. As Adams explained,

The great danger to self-government in the United States lies in municipal corruption, and municipal corruption is in large measure traceable to the manner in which cities have used their credit. For American readers, this reference to local government is a pertinent illustration of a most dangerous political tendency of deficit financiering. . . . The tendency of foreign borrowing is in the same direction as that of domestic borrowing. As the latter obstructs the efficiency of constitutional methods, so the former tends to destroy the full autonomy of weak states. The granting of foreign credit is a first step toward the establishment of an aggressive foreign policy, and, under certain conditions, leads inevitably to conquest and occupation. (Henry C. Adams, Public Debts, An Essay in the Science of Finance. New York: D. Appleton and Company, 1898, 25.)

If mere borrowing the existing accumulations of savings is so dangerous to individual sovereignty and human dignity, how much more so is handing over the key to the "money machine" to the politicians? That, however, is exactly what has happened in the United States and in virtually every other country on the face of the earth that subscribes to the tenets of the Currency School instead of the Banking School as the basis for its monetary and fiscal policy.

The degeneration was extremely rapid, as was only to be expected once the United States managed to cut itself loose from the inconvenient orientation toward individual sovereignty, human dignity, and the rule of law. Soon after the Federal Reserve System was established, it succumbed to political pressure. This started with the diversion of the Federal Reserve's money creation powers to finance of World War I. It continued with the establishment of the Open Market Committee in the 1930s, accelerated with the Employment Act of 1946, and has, apparently, reached its final, if inevitable end with the bailouts and subsidies to failed companies and to support prices on the stock market with purchase of mortgage-backed "toxic assets."

In consequence, perhaps no institution in history aside from organized religion has been the object of so much intrigue, hatred, and suspicion as the Federal Reserve System. Consequently, the usual demand is that the institution be abolished and that the State must take over the creation of money. This would, presumably, abolish all taxes and establish a universal reign of plenty and prosperity forever and ever.

There are a few things wrong with this solution, not the least of which is that, even if feasible, would any sane person want to give the State absolute power over the life's blood of the economy, thereby giving the State total power over every aspect of every individual's life? The answer to that, obviously, is "no." It is not, however, merely a question of how best to avoid giving the State totalitarian power. There is also the simple fact that allowing the State, which by its nature does not produce anything, the power to create money. Money being a derivative of production, it must, as Irving Fisher pointed out in The Purchasing Power of Money (1911), be linked through private property to the assets that back the money.

Because the State does not produce marketable goods and services — the assets that, ultimately (per Say's Law of Markets) stand behind money — the State, in order to back the money it issues, necessarily makes a claim on the marketable goods and services produced by others. If the State issues only a part of the money supply, it lays claim to only a portion of the wealth possessed by its citizens. If State creation of money is kept within bounds, the citizens may find it tolerable, regarding the inflationary effect of issuing money backed by future tax revenues as a more or less "hidden tax," that is, an indirect tax on their wealth.

If, however, the State creates money at too great a rate (as, historically, it has a tendency to do), the hidden tax of inflation may be too great to bear, and can even destroy the State, either through collapse of the financial system, or through the loss of sovereignty as foreign interests step in to protect their investments. Finally, if the State creates all money — a virtual impossibility, even in a socialist or communist State, given that money is properly defined as anything that can be used in settlement of a debt — the State declares itself de facto sole owner of everything in the economy. This is because the State has taken the right of disposal away from the nominal owners, and vested that right in itself. The State thereby becomes socialist, whatever it might call the arrangement, for it has thereby abolished private property by taking away a fundamental right of private property.

The other way in which a State can become socialist without either calling itself so or by assuming legal title to anything is to confiscate all income, whether through direct taxation, or through the hidden tax of inflation. The program described by Henry George in Progress and Poverty (1879) is an example of abolishing private property in land by taking all profits ("rents") of land through direct taxation, thereby abolishing the right of an owner to receive the fruits of ownership of land.

Major C. H. Douglas's social credit proposal is an example of how private property in capital instruments other than land would be abolished by indirect taxation. Douglas would require the State to issue all money, to be backed by the marketable goods and services produced each year, which Douglas asserted belongs to the collective. Private property in the "fruits of ownership" (production), a fundamental right of private property, would be abolished, and distributed by the State as a national dividend to every citizen, after deductions for necessary State expenditures.

Most modern States prefer an even more indirect method of implementing socialism and increasing their power. Paradoxically, this inevitably results in a loss of State power, which follows hard on the heels of the loss of individual sovereignty that necessarily accompanies State control of money and credit, and through those uniquely social goods, the economy as a whole.

Part of the problem, as we might expect, is reliance on the disproved, even nonsensical Keynesian "paradox of thrift." Policymakers and academic economists have allowed themselves to be persuaded that government debt is a positive good, rather than an intolerable evil. Most simply put, the Keynesian "paradox of thrift" is that it is good for individuals to save, but not good for the economy as a whole. By saving, that is, cutting consumption, individuals increase their personal wealth, but reduce aggregate demand. At the same time, the reduction in aggregate demand means that businesses are less able to prosper, or even survive. They start laying off workers and reducing the number of jobs. This reduces aggregate demand still further, causing a vicious continuing spiral downward. This causes a recession or depression to be self-perpetuating.

To be perfectly accurate, Keynes did not invent this observation. It dates back at least to the middle of the 18th century, and possibly before. What Keynes added was the idea that government "dissaving," that is, deficit spending, would cause "forced saving" through inflation. According to Keynes, forced saving transfers purchasing power from savers to investors by raising prices. A rise in prices causes consumers to spend more for the same amount of goods and services or, if income is fixed (as wages tend to be "sticky" in the short run), cut consumption while still expending the same or greater amounts of money to maintain their current standard of living.

As Moulton pointed out, the flawed approach to finance embodied in Keynesian economics means that "saving" is always defined as cutting consumption. Raising prices "forces" reductions in consumption that thus qualify as "savings." The resulting transfer of purchasing power from savers to investors provides the necessary accumulated savings (that in Keynesian economics and all other schools of economics based on the tenets of the Currency School must always precede investment) that investors require to finance new capital formation.

One problem becomes how to induce inflation and increased spending so as to bring about forced savings to the advantage of wealthy investors and to the detriment of small savers. Another problem is how to persuade businesses to use the forced savings they accumulate to invest in new capital formation, thereby creating jobs and increasing aggregate demand. As unemployment increases, aggregate demand falls, and businesses have no incentive to invest in new capital formation.

Within the framework dictated by Keynesian economics, then, the economy is ground between the upper and nether millstones of consumers who won't spend, and businesses that won't invest. Keynes, however, believed he had the answer: only the State (of course) can overcome the paradox that what is good for individuals is bad for the economy.

The main thing is to increase the money supply. "Money," of course, is always defined solely in terms of currency and demand deposits. Money, in Keynesian economics, is never defined in terms of privately issued promissory notes and other negotiable instruments by means of which more than 60% of financial transactions are currently carried out in the United States.

The first step is always to cut interest rates, regardless of the market cost of capital or what is due in justice to savers who presumably supply the financing for new capital formation. Lowering the interest rate presumably encourages businesses to borrow existing accumulations of savings in order to invest, thereby putting the savings to use. The fact that savings are rarely directly used to finance capital formation is irrelevant in Keynesian theory. All schools of economics based on the tenets of the Currency School assume as a given that existing accumulations of savings are used to finance capital formation, so all prescriptions are based on this incorrect — and extremely damaging — assumption. Bank credit, presumably based on a limited amount of existing savings, is thus a commodity, and is therefore subject to the laws of supply and demand. If you want to increase demand for the existing supply of loanable funds, you lower the price — the interest rate. If you want to decrease demand, you increase the price.

There is, however, the problem of the "liquidity trap." This is when, no matter how low interest rates go, businesses will not borrow. The demand for the existing supply of savings — "loanable funds" — becomes "infinitely elastic," although at other times it exhibits the usual degree of inelasticity. It doesn't matter how low the "price" goes, borrowers will not demand any more than they would otherwise have demanded.

Thus, under certain conditions, bank credit, for some strange reason, refuses to obey the laws of supply and demand. The possibility that this is because bank credit, not really being based on or determined by the amount of savings existing in the economy, is not a commodity does not seem to occur to policymakers and academic economists. There is also the problem that "interest," properly speaking, is not the "rent" or the "price" of money, but a lender's just share of profits (when not manipulated by the State or other authority in place of the State) adds to the problem.

The real cause of the "liquidity trap," of course, is lack of adequate collateral. The liquidity trap is not due to any real unwillingness on the part of banks to lend — making loans is how banks make profits, and it is contrary to human nature to assert that bankers do not want to make profits. The direct cause of the so-called "liquidity trap" is usually a drastic decline in the value or quality of the existing wealth that usually serves as collateral, not a general or stubborn unwillingness of banks to lend.

The Keynesian solution, however, is not to search for a replacement for the usual forms of collateral, but to inject more money in the economy. This raises the price level, causes "forced savings," and increases effective demand by inducing inflation and distributing the new money through increased welfare, job creation, or direct subsidies to business — whatever will presumably get money into the hands of people who will spend it on consumption.

A lowering of the price level is, in the Keynesian framework and other schools of economic thought based on the tenets of the Currency School, an utter disaster. The possibility that production of marketable goods and services is not due to human labor alone, and that technology is hyper-productive compared to human labor, does not enter into the discussion. "Productivity" is defined as "production per labor hour." This definition ignores or dismisses all non-human factors of production.

If, as is the case under the tenets of the Currency School, there is a fixed amount of savings in the economy, and all new capital investment can only be financed out of this existing accumulation, a reduction in the price level allows the wrong people to save. As Keynes quite logically points out, under his assumption that capital formation can only be financed out of existing accumulations of savings, there must necessarily be as few savers as possible.

These few savers (ideally only the State) must reinvest all of the income generated by capital into financing new capital formation. Only in this way can jobs be created and effective demand kept up throughout the economy. Inflation of the currency by the State presumably solves what Moulton called the "economic dilemma" (The Formation of Capital, op. cit., 26-36) by transferring savings from the wrong savers to the right savers, whether a private financial elite, or the State.

Even Irving Fisher, a monetarist, advocated "reflation," or State issues of fiat money, as the solution to the Great Depression. The argument goes something like this: 1) If people are able to obtain the same or greater quantity or quality of marketable goods and services at a lower cost than before, they can save more money. 2) If people save, however, they are cutting consumption, which reduces aggregate demand. 3) Reducing aggregate demand means that businesses will make less profit, or no profit, and go out of business. Therefore, 4) the price level must be raised by inflating the currency, and the new money distributed to people who will not save it, but spend it on consumption.

The bottom line to this reasoning is that the State necessarily maintains a large and increasing floating debt. That in the long run this means that every economy on earth will necessarily go bankrupt when the bill comes due is irrelevant. As Keynes remarked, "In the long run we are all dead." Who, then, needs to care what happens in the future?

The problem, of course, is that while Keynes's solution of always increasing the amount of State debt seemed to work to bring about a recovery from the Great Depression (although we have already seen that this so-called recovery was an illusion), somebody in the future ends up paying for what the State spends. Unfortunately for us, we are the future — the long run — that Keynes dismissed as irrelevant. However irrelevant we may have been to Keynes, though, we happen to be very relevant to ourselves. The current economic crisis suggests in the strongest terms possible that the bill has come due, and that we are, economically speaking, and in Keynesian terms, "dead."

Fortunately, however fervently Keynesians and other Currency School dévots believe that new capital formation can only be financed out of existing accumulations of savings, and that these savings can be forcibly transferred from small savers to investors or the State through inflation and maintenance of a large and increasing State debt, the truth is otherwise. As Moulton proved in The Formation of Capital (loc cit.), there is no "economic dilemma." The so-called economic dilemma that appears to require massive State debt simply does not exist.

The dilemma assumes as a given that capital formation can only be financed out of existing accumulations of savings — which we know is not the case. As Moulton pointed out, and as we have cited on more than one occasion, new capital formation has frequently been financed not out of existing accumulations of savings, but by means of the expansion of commercial bank credit, backed by the present value of existing or future marketable goods and services. (Ibid., 104.)

This is because, contrary to what economists tend to believe, whether they are Keynesians, Monetarists, or Austrians (or some variation thereon), the money supply consists of far more than M1 and M2 — that which the Federal Reserve currently defines as the "money stock." Money actually consists of anything that can be used in settlement of a debt. As we have seen, by far the larger amount of money in circulation consists not of coin, currency, or checks, but of commercial paper, merchants and bankers acceptances, bills, notes, etc.: private sector money. Private sector money is often issued by a commercial bank or other financial institution in the form of a promissory note, but can take many forms, even issued by a private company in an example of disintermediation. All of this is "money," and it all circulates. It is also the soundest money, because it is backed by the present value of existing and future marketable goods and services, not a State promise to pay out of future tax revenues.

There is thus almost no reason whatsoever that can justify a sizable State floating debt, or, frankly, a State debt of any size for anything other than the short term. This is true whether we are discussing the issue in terms of economic necessity and the source of financing for new capital formation, or political expedience when the State requires money to carry out some project.

There are two exceptions to what should be an absolute ban on State debt. The first exception, hinted at above, is purely a matter of political expedience. That is, State expenditures, even when tied absolutely to the actual amount of tax revenues, frequently do not match with tax revenues. The State needs to expend funds continuously to meet its obligations. In general, however, it cannot collect taxes continuously, even with the modern withholding system. Just as a business or an individual sometimes needs to borrow to meet a temporary shortfall in cash, the State may need to borrow in the short term to keep running until tax collections come in.

The other exception is also a matter of political expedience. When a State has already committed every available resource to its survival, as in total war, and still lacks the wherewithal to defend itself adequately, the State may justify borrowing from other States.

In neither case, however, can the State justify creating money, either directly, or through its central bank or the commercial banking system. All loans to the State, just as with loans for consumption and speculation, must come out of existing accumulations of savings. To protect the sovereignty of its citizens and ensure its own independence, the State must never make promises on which it does not have the power or ability to deliver out of existing resources or in the immediate future.

In practical terms, of course, we cannot expect the federal government (or any government, for that matter, local, regional, or national) to stop borrowing immediately. Virtually every government on the face of the earth today is a debt addict. As with any addiction, going "cold turkey" can cause more problems than the addiction, sometimes even death if withdrawal symptoms are severe enough.

As a matter of political expedience, we must permit the State to continue to borrow until financial reforms have rebuilt the tax base to the point where massive borrowing is no longer necessary, and today's massive outstanding State debt can be retired. At that point — and rough estimates suggest that restoring the tax base could take a generation — the State can stop all borrowing, except to meet temporary shortfalls in tax collections.

We cannot, however, permit the State to monetize its deficits, whether in the short term or the long term. To do so is, as we have seen, both political and economic suicide. That is why, above everything else, all money creation for State purposes, whether for political or economic ends, especially by the Federal Reserve — the central bank of the United States — must cease immediately.

To this we necessarily add that all money creation for consumption purposes, as well as for anything that is not a properly vetted and adequately collateralized capital project intended to result in the production of marketable goods and services must also cease immediately. No other course of action is in any way acceptable or even possible.